End of Chinese currency peg signals a global shift

Opinions seem to have shifted in the short time since China announced it was breaking the link between the renminbi and the dollar on July 21 (see Fund Strategy, July 25, page 5). At first there was much talk of it being an important move that could open the way for a substantial revaluation of the Chinese currency. More recently many commentators have emphasised that the practical impact of the change is likely to be small.

Both sides tend to miss the longer-term significance of the change. They are preoccupied with how far the renminbi is likely to move versus the dollar over the coming weeks or months. A longer-term perspective yields different conclusions about the significance of the shift.

The key point to understand is that changes to exchange rate regimes generally reflect broader economic and geopolitical shifts. Market forces may affect the day-to-day or week-to-week moves in exchange rates. Speculative players, such as hedge funds, can also have a short-term effect. But in the longer term broader trends have the decisive impact.

This point should be clear with the benefit of hindsight. In the 1930s Britain broke away from the gold exchange standard (see box above) because it was no longer economically strong enough to maintain sterling’s link to gold. Britain had gone from being the workshop of the world in the late Victorian era to one of several powers contesting global economic leadership. The Bretton Woods era reflected America’s emergence as overwhelmingly the world’s strongest economic power after the second world war. More recently Britain’s ejection from the Exchange Rate Mechanism resulted from the country’s inability to tie itself to a (then) much stronger German economy.

In relation to China there is less time for hindsight available than for any of the other events. But it should be clear by now that the emergence of China as an economic power is a truly historic event. When a nation of 1.3 billion people grows its GDP at over 8% a year for more than a quarter of a century, its impact is substantial. While China was coming from a low base, its economy is now one of the largest in the world. It is also one of the world’s biggest trading powers and the single largest recipient of foreign direct investment.

The New Dollar Area during which the renminbi and other Asian currencies were pegged to the dollar – was itself partly an expression of China’s growing power. A US economy increasingly beset by economic imbalances needed Asian support to keep it going without painful readjustment. The renminbi peg meant that, in effect, China was subsidising its exports to America by keeping them artificially cheap.

It is important to recognize that the relationship between China and America would probably not have been so harmonious had it not happened in the post-Cold war period. With America as the world’s only superpower it was less likely to feel threatened by China as a potential rival. It was therefore easier for the US to become reliant on China without feeling it was giving too much away.

In the short term the New Dollar Area could well continue in a modified form. Although the renminbi is no longer officially pegged to the dollar it could still move closely in line with it.

However, America has probably set a new dynamic in motion by putting pressure on China to abandon the peg. Although the relationship between the two sides is still generally harmonious, it looks set to become more troubled over time. The relationship between America and China is likely to be a key factor shaping the world economy in the period ahead.